Signs point to a rotation from defensive sectors into aggressive, cyclical industries. / Thinkstock

by John Spence, Special for USA TODAY

by John Spence, Special for USA TODAY

They say the best defense is a good offense. That could be the case in sector ETFs amid signs investors are rotating from defensive, dividend-paying sectors that have outperformed this year into aggressive, cyclical industries.

ETFs tracking conservative sectors such as consumer staples, health care and utilities were the big winners in 2013 heading into May. These industries, which are less sensitive to the economy, helped power the Standard & Poor's 500 to all-time highs.

Yet market trends the past couple weeks have pointed to a so-called cyclical sector rotation. In other words, investors may be switching from defense to offense in their sector preferences.

For example, Utilities Select Sector SPDR ETF (XLU) was beating the S&P 500 by 6 percentage points year to date through April 15. However, that edge has been quickly and completely erased in May, with utilities the S&P 500's worst-performing sector so far this month. The utilities ETF is down nearly 3% in May, the only one of the nine U.S. sectors in the red. That same period the S&P 500 is up more than 4%.

Consumer Staples Select Sector SPDR ETF (XLP) and Health Care Select Sector SPDR ETF (XLV) are also faltering relative to the S&P 500 in May after leading during the first four months of 2013.

Cyclicals taking over the leadership baton is seen as a positive sign for the market and an indication that investors are taking on more risk. They're moving away from the stodgier sectors and into industries that should benefit if the economy picks up speed.

"We're seeing about half of the market that's been forsaken getting involved, and that's healthy for the next move," says Josh Brown, a financial adviser at Fusion Analytics who runs The Reformed Broker blog.

Tech, industrials and materials have outperformed recently, something investors haven't seen in awhile, he notes.

"The market is up this year but has been running with ankle weights on with so many stocks not performing," Brown adds. "Is that going to change? We don't know for sure, although it certainly seems that way, which is a positive development."

PAYING UP FOR SAFETY

The penchant for defensive, dividend-oriented stocks in the wake of the financial crisis is apparent in the elevated price-to-earnings multiples that investors have bid up in these sectors. These "safety" sectors have also gotten attention from bond investors looking for yield in a low-interest-rate environment.

"The preference for current income is reflected in the fact that companies from defensive sectors are currently trading at a premium valuation. Defensive stocks typically have higher dividend payouts because they are in mature industries, have few opportunities for organic growth, and have less of a need to reinvest cash internally," says Morningstar ETF analyst Michael Rawson.

"Because of their slower growth, we would expect them to trade at a discounted valuation. But that is not what we see in the current environment," he adds.

Therefore, the traditional safety sectors could actually be the riskiest from a valuation perspective.

In fact, cyclicals are currently more undervalued to defensive sectors than at any time in the past 15 years, Goldman Sachs said in a note earlier this month.

"Assuming U.S. GDP growth can exhibit some signs of reacceleration during the second half of 2013, currently identical 2014 sales and earnings estimates mean investors can buy growth at a discount," the report said.

If valuations begin to revert back to historical norms, cyclicals should outperform defensives during the next 12 months, Goldman said.

ETFs FOR CYCLICALS AND GROWTH

ETFs offer low-cost, liquid vehicles to buy entire sectors with one trade and low costs. Therefore, they can be used to "tilt" portfolios toward relatively cheap cyclical sectors that could be poised to outperform the rest of 2013.

Other large ETFs for the tech sector include Vanguard Information Technology ETF (VGT), the Nasdaq-100 PowerShares QQQ (QQQ), iShares U.S. Tech ETF (IYW) and First Trust Technology AlphaDEX ETF (FXL).

Conversely, investors who have piled into popular dividend-themed and low-volatility ETFs should be aware these funds can be heavily concentrated in the conservative sectors that look pricey after a strong run.

Ned Davis Research pointed out in a report that if these sectors pull back, "some ETF and mutual fund investors will be in for a rude awakening if they aren't watching their underlying sector exposure."